Option Volatility & Pricing Strategies

The valuation of an option remains a puzzle, influenced by numerous variables. While some factors, such as the underlying asset’s current price, strike price, and option type, have known values, others, like the time to option expiry, interest rate, and dividends from the underlying asset, require deeper comprehension. Notably, one crucial factor with an indeterminate value is volatility.

Trading often adheres to the fundamental principle of balancing Risk versus Returns. This implies that higher risk is associated with the potential for greater returns. Volatility manifests in two forms: Historical Volatility and Implied Volatility. Historical volatility reflects the actual volatility of the underlying asset over a specific period, like a month or a year. Conversely, Implied Volatility indicates the fluctuation of stock option volatility levels implied by the current option price.

While both historical and implied volatilities coexist, the latter holds greater significance. Implied volatility has a unique relevance as it accurately mirrors the current market conditions, providing valuable insight into the present risk landscape and an opportunity to evaluate future risks. This distinction is not reflected in historical volatility.

One could argue that market dynamics follow a cyclic pattern, with tendencies to repeat in the future, and this holds true to a certain extent. However, the market’s cyclical nature has proven effective in predicting market rises or falls, often falling short in gauging the magnitude of downturns.

During volatile periods, diverse trading strategies emerge. While novice traders often opt for conventional calls or puts (also known as plain-vanilla calls or puts), seasoned traders employ various strategies such as Strangles, Go long, Go short, and Iron Condors. The option volatility and pricing strategies hold their unique characteristics, and a brief exploration of each can enhance understanding.

What is option volatility?

In options trading, it is crucial for a trader to be acquainted with the diverse factors and variables influencing the price of an option contract. There are a total of 7 variables play a role in determining an option’s price. Among these variables, 6 have predetermined values incorporated into the option pricing model, while volatility remains an estimated factor. The following are the variables influencing option pricing.

• Underlying security price
• Time to expiry of the option
• Option’s type – Call or put option
• Dividends offered by the underlying
• Risk-free interest rate
• Volatility
• Strike price

Volatility is inherently changeable and lacks a constant value. Implied Volatility (IV) holds substantial influence over option prices, projecting the expected volatility in the underlying asset’s price. Higher IV typically corresponds to elevated option premiums. While traders should be acquainted with Historic Volatility (HV), which reflects the past volatility of an underlying asset over a specific period, it is crucial to note that IV plays a more pertinent role in options trading by aiding in anticipation of future volatility.

Planning with option volatility and pricing strategies

The market acknowledges five established strategies for stock option volatility and pricing to plan trades strategically based on implied volatility (IV). These option volatility and pricing strategies are outlined below.

Naked call or put

Engaging in purchasing or selling naked options is a direct method, but it demands a certain level of expertise for adept navigation. This strategy entails buying or selling options without possessing the underlying asset. Traders frequently opt for selling naked put options when anticipating a bullish market sentiment coupled with a level of volatility. 

With the market on an upswing, the trader benefits from the rising premium of the put option. Conversely, selling a call option can yield profits when anticipating a downturn. However, it is essential to acknowledge that selling naked options involves unlimited risk, particularly in volatile market conditions.

Short strangle and short straddle

Short strangles entail the sale of both call and put options at identical strike prices, proving advantageous when there is an anticipation of a decrease in implied volatility (IV) nearing expiration. This approach enables traders to capture the premiums from both options. On the other hand, short straddle option volatility and pricing strategies involve selling call and put options with varying strike prices, ensuring that the call option’s strike price surpasses that of the put option.

Iron condor

The Iron Condor strategy involves executing out-of-the-money call and put option spreads, enhancing profit potential and reducing risk in comparison to short strangles. In this strategy, a trader takes a long position on both a call and a put option while simultaneously establishing short positions on one call and one put option. It’s essential to emphasize that each of the four option contracts must have distinct strike prices.

Ratio writing

Ratio writing is a trading approach involving applying a designated ratio to the options sold and bought. For example, a ratio of 2:1 indicates that two options are sold for every option purchased. This strategy aims to capitalize on the expected decline in implied volatility options (IV) as the expiration date approaches.

Factors affecting option volatility

Specific factors affecting option volatility encompass:

• Market conditions: Factors like political instability and economic turmoil leading to market uncertainty can elevate volatility.
• Supply and demand: Increased demand for a specific option tends to raise volatility, whereas abundant supply may have the opposite effect.
• Economic indicators: Earnings reports, releases of economic data, and other financial indicators have the potential to influence the volatility of options associated with a particular stock or index.

For traders aiming to formulate effective trading option volatility and pricing strategies capitalizing on market inefficiencies, gauging volatility is imperative. Through measuring volatility and a comprehensive understanding of its determinants, traders can pinpoint opportunities to buy or sell options for profit. Various tools and techniques are available for measuring volatility, including:

• Statistical models: The prevalent statistical model’s standard deviation is employed to gauge volatility.
• Implied volatility: Calculated using the option’s current market price, implied volatility options reflect the market’s anticipation of future volatility.
• Historical volatility: Computed based on the actual prices of the underlying asset over a specified period, historical volatility provides insights into past market movements.

Conclusion

Options trading has the potential to yield significant profits, but it also necessitates sophisticated trading techniques and a thorough grasp of option volatility and pricing. A crucial component of options trading is option volatility, which traders need to understand how to measure and what influences it. Options pricing is mainly determined by pricing algorithms, including the Black-Scholes and binomial models, which provide traders with a variety of approaches to the market. 

More flexibility and possible rewards are available to traders using option volatility and pricing with sophisticated trading methods, including spreads, straddles, and strangles; nevertheless, the trader’s risk tolerance and market perspective must be carefully considered. By comprehending these fundamental ideas and tactics, traders may make well-informed and lucrative decisions in the options market.

FAQs